Economic profit is the difference between a firm’s total revenue and the full economic cost of the resources used to generate it. Unlike accounting profit, it deducts both payments to outside suppliers and the opportunity costs of resources supplied by the owners themselves. In microeconomics, the concept distinguishes earning income from earning more than those resources could obtain in their next-best alternative use. A business can therefore report positive accounting profit while earning zero or negative economic profit. (openstax.org)
Definition and calculation
The standard expression is:
[ \pi_e=TR-C_{\mathrm{explicit}}-C_{\mathrm{implicit}}, ]
where (\pi_e) denotes economic profit, (TR) total revenue, and the two cost terms represent explicit and implicit costs.
Explicit costs are payments for inputs, such as employees’ wages, purchased materials, and rented premises. Implicit costs represent forgone returns on owner-supplied resources: unpaid managerial work, buildings used rather than rented out, or funds invested in the business rather than elsewhere. These costs exist even when no corresponding payment appears in the firm’s records. (openstax.org)
In the simplified textbook framework:
[ \pi_a=TR-C_{\mathrm{explicit}}, \qquad \pi_e=\pi_a-C_{\mathrm{implicit}}. ]
This comparison does not mean that financial accounting measures only cash receipts and payments. Under accrual accounting, transactions affect reported performance in the periods when their economic effects occur, which may differ from the timing of cash movements. Recorded expenses can also include depreciation. The essential distinction is the treatment of opportunity costs, not simply whether an expense involves cash. (openstax.org)
Illustrative example and normal profit
Consider a hypothetical owner-operated business with annual revenue of $300,000 and explicit costs of $220,000. Its simplified accounting profit is $80,000. Suppose the owner could earn $60,000 in alternative employment, rent the premises to another business for $15,000, and obtain a comparable-risk return of $10,000 on the invested funds. Assuming these alternatives are compatible and none is already counted, implicit costs total $85,000:
[ \pi_e=300{,}000-220{,}000-85{,}000=-5{,}000. ]
The business produces income but earns $5,000 less than the specified alternative uses of its resources. This is an illustration of the opportunity-cost framework rather than an observed business case. (assets.openstax.org)
Zero economic profit means that revenue covers all economic costs, including the returns required to retain owner-supplied resources. This situation is commonly described as earning normal profit. It does not mean owners receive nothing: their labor and invested resources are compensated within economic cost. Positive economic profit is a surplus above that benchmark; negative economic profit indicates a shortfall relative to it. (assets.openstax.org)
Competition and long-run equilibrium
In the standard model of perfect competition, firms sell identical products, take the market price as given, and face unrestricted entry and exit. Positive economic profits encourage entry. Additional output increases market supply and tends to reduce prices; losses encourage exit, reducing supply. Through these adjustments, the industry approaches a long-run equilibrium with zero economic profit. (openstax.org)
For the representative firm in the usual identical-firm model, long-run equilibrium occurs where price equals minimum average total cost. Because that cost includes opportunity costs, the zero-profit result remains compatible with positive accounting earnings. It is a conditional model result, not a claim that every competitive business always earns exactly zero economic profit. (assets.openstax.org)
With barriers to entry, above-normal profits need not attract enough competitors to eliminate them. Monopoly and other forms of market power can therefore permit persistent economic profits. Relevant barriers include control of essential resources, patent protection, and cost advantages associated with economies of scale. Such barriers make profits possible but do not guarantee them. (openstax.org)
Output decisions and temporary losses
Economic profit is a total measure, whereas output choices depend on marginal comparisons. At an interior profit-maximizing output, marginal revenue equals marginal cost, subject to the appropriate maximizing conditions. For a competitive firm, marginal revenue equals price. When economic cost is used consistently, profit can also be written as:
[ \pi_e=(P-ATC)Q, ]
where (ATC) is average total cost and (Q) is output. (assets.openstax.org)
Negative economic profit does not necessarily imply immediate shutdown. In the standard short-run competitive model, a firm may continue producing when revenue covers variable costs and contributes toward unavoidable fixed costs. The shutdown threshold is minimum average variable cost, whereas covering average total cost determines whether economic profit is nonnegative. (assets.openstax.org)
Corporate-finance measures and measurement limits
In corporate finance, a closely related measure subtracts a charge for invested capital from after-tax operating income:
[ EP=NOPAT-kK, ]
where (NOPAT) is net operating profit after tax, (k) the cost of capital, and (K) invested capital. Equivalently, it equals invested capital multiplied by the difference between return on invested capital and its required return. Economic value added applies this surplus-return logic, often with adjustments to accounting income and capital. (pages.stern.nyu.edu)
These calculations depend on measurement choices. The capital base may require adjustments when book values poorly represent resources committed to the business; operating income may require consistent treatment of leases, research and development, and exceptional charges. A positive capital-based economic profit indicates returns exceeding the selected capital charge, but its magnitude depends on those estimates. (pages.stern.nyu.edu)